How a $1-trillion time bomb posts a phony profit

BloombergApr 12, 2010, 06.31am IST

The Federal home loan banks are a frequently overlooked band of government-chartered co-operatives whose name screams systemic risk with every word. Federal means Uncle Sam. Homes are a declining asset. A loan is money out the door. And banks are the things that get taxpayer bailouts when they're too big to fail and enough of their loans go bad.

So perhaps, it shouldn't come as a surprise that these 12 regional lenders collectively suffered massive losses last year. What's astonishing is that you wouldn't know it by looking at their bottomline earnings or from the strange way their regulator measures their capital cushions.

Last week, the FHLBs, which is pronounced "flubs," published their combined audited financial statements for '09. And at first glance, it might seem like they had a profitable year. Net income was about $1.9 billion, the banks said, up 54% from the year before.

The most striking part about that dollar figure was what it didn't include: about $8.8 billion of paper losses from their portfolios of mortgage-backed securities. By the banks' own description, these losses were "other than temporary," meaning the values of the investments aren't expected to recover soon.

The reason those losses weren't included in earnings? The Financial Accounting Standards Board rewrote its rules a year ago so they wouldn't have to count, following an intense campaign by the banking industry and its friends in Congress. One thing the rule change couldn't do, though, was make those losses go away in real life.

AMONG BIGGEST BORROWERS

With more than $1 trillion of assets and about $973 billion of liabilities, the FHLB system is among the largest US borrowers after the federal government, bigger even than Fannie Mae or Freddie Mac. Operating independently, the FHLBs make low- cost loans to about 8,000 member banks and finance companies. They also sport AAA credit ratings from Moody's Investors Service and Standard & Poor's , which keeps their borrowing costs low, because their debt has an implicit federal guarantee. Thanks to the FASB rule change, the banks got a new way to report phony profits, too.

Before '09, whenever companies wrote down debt securities that they labelled as held-to-maturity or available-for-sale , their earnings had to include any losses they deemed other than temporary. Now they get to separate the writedowns into two parts: estimated future credit losses and everything else. The first kind reduces earnings and regulatory capital. The other doesn't , although both types must be included in the asset values on their balance sheets.

LOWBALL NUMBERS:

The fallacy of this approach is that it's impossible to discern how much of a bond's decline in market value is due to perceived future credit losses versus other factors, such as liquidity risk. The obvious incentive for companies is to lowball their estimates of credit losses. The FASB rule change was one of the reasons cited by former US Comptroller General Charles Bowsher when he resigned as chairman of the FHLBs' Office of Finance in March '09, saying he was uncomfortable vouching for the banks' numbers.

Combined, the 12 banks reported $11.2 billion of other-than-temporary losses on their mortgage-backed securities last year. However, they said only $2.4 billion was related to credit losses, as if they had the ability to know.

Here's how those numbers affect the banks' capital ratios. The general rule is that the banks' regulatory capital must equal at least 4% of assets. By that measure, all 12 of them exceeded the government's minimum requirement, as of December 31. The catch is that the government's measure ignores lots of red ink, such as the aforementioned $8.8 billion last year, and treats some types of debt as if they were assets.

FOUR FALL SHORT :

Had the government's 4% benchmark been based on actual capital, rather than a fantasy version of the assets on their books, four of the 12 banks would have fallen short: those in San Francisco, Seattle, Chicago and Indianapolis. The San Francisco bank, the largest of the group, was credited with having $14.7 billion of regulatory capital, or 7.6% of assets. By comparison, its balance sheet showed just $6.2 billion of total capital, for a 3.2% ratio.

The Seattle bank is another extreme example. It showed $993.7 million of total capital on its balance sheet, or 1.9% of assets. That's 51-to-1 leverage, far more than the Wall Street casualty Lehman Brothers ever disclosed. Yet the banks' regulator, the Federal Housing Finance Agency, credited it with $2.8 billion of regulatory capital, or a 5.6% ratio.

IMAGINARY ACCOUNTING:

Even with the liberal accounting rules, the Seattle bank still showed a $161.6-million net loss, which excluded about $1 billion of "non-credit" investment losses. Fortunately, its regulator isn't totally blind. Last year, it classified the Seattle bank as undercapitalised anyway, partly out of concern the investment losses there may keep growing. All told, the 12 banks reported a combined $42.8 billion of total capital on their December 31 balance sheets, or 4.2% of their assets. The government gave them credit for $60.2 billion of regulatory capital, much of which was imaginary.

The only thing bond investors care about, of course, is whether the US Treasury would ever bail out these banks if needed. Undoubtedly, it would. The bull market in moral hazard rages onward.